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Mar 24

Tim O'Reilly

Tim O'Reilly

Subprime Loans Glossary

Ben Lorica, our senior research analyst, wrote in email recently: "How out of control was the subprime loan market? Steve Pearlstein had a great column about the subprime loan market a few weeks ago, where he summarized some of the "innovations" that were marketed heavily until recently. My personal favorite is the NINJA loan: No Income, No Job, No Assets!" Other "how could they?" loans include the "liar loan" in which the borrower needs to provide no documentation on claimed income or assets, and the "teaser loan", which gives an artificially low rate for two years, before dropping the hammer on someone who will never be able to make the real payments.

The article provides good insight into the evolution of financial instruments from someone's creative money-making hack to wild speculation and eventual collapse:

It began years ago when Lewis Ranieri, an investment banker at the old Salomon Brothers, dreamed up the idea of buying mortgages from bank lenders, bundling them and issuing bonds with the bundles as collateral. The monthly payments from homeowners were used to pay interest on the bonds, and principal was repaid once all the mortgages had been paid down or refinanced.

Thanks to Ranieri and his successors, almost anyone can originate a mortgage loan -- not just banks and big mortgage lenders, but any mortgage broker with a Web site and a phone. Some banks still keep the mortgages they write. But most other originators sell them to investment banks that package and "securitize" them. And because the originators make their money from fees and from selling the loans, they don't have much at risk if borrowers can't keep up with their payments.

And therein lies the problem: an incentive structure that encourages originators to write risky loans, collect the big fees and let someone else suffer the consequences.

This "moral hazard," as economists call it, has been magnified by another innovation in the capital markets. Instead of packaging entire mortgages, Wall Street came up with the idea of dividing them into "tranches." The safest tranche, which offers investors a relatively low interest rate, will be the first to be paid off if too many borrowers default and their houses are sold at foreclosure auction. The owners of the riskiest tranche, in contrast, will be the last to be paid, and thus have the biggest risk if too many houses are auctioned for less than the value of their loans. In return for this risk, their bonds offer the highest yield.

It was this ability to chop packages of mortgages into different risk tranches that really enabled the mortgage industry to rush headlong into all those new products and new markets -- in particular, the subprime market for borrowers with sketchy credit histories. Selling the safe tranches was easy, while the riskiest tranches appealed to the booming hedge-fund industry and other investors like pension funds desperate for anything offering a higher yield. So eager were global investors for these securities that when the housing market began to slow, they practically invited the mortgage bankers to keep generating new loans even if it meant they were riskier. The mortgage bankers were only too happy to oblige.

I've been thinking a bit about the parallels between the Web 2.0 economy and financial markets. I'm mostly looking at positive developments, but it's not out of the question that as the current mini-bubble continues, we could see "innovations" in the Web 2.0 economy that have similar destructive market potential as we've seen in the mortgage market. If you see any crazy business models that could run out of control and turn destructive, we'd love to hear about them.

Update: I just picked up yesterday's paper and noticed that the New York Times ran a story entitled The Subprime Loan Machine that is very relevant to this entry, but also to my recent entry on the troubles at the Chronicle:

"The rise and fall of the subprime market has been told as a story of a flood of Wall Street money and the desire of Americans desperate to be part of a housing boom. But it was the little-noticed tool of automated underwriting software that made that boom possible....Automated underwriting is now used to generate as much as 40 percent of all subprime loans.

The point, I think, is that in many ways the financial markets prefigure much of what is to come in Web 2.0. As trading has become automated, the differences between a hedge fund or an automated mortgage lender and a Google may narrow, both relying increasingly on systems that have the potential to run wildly out of control. One of Google's secret weapons may be the power that their search quality team wields -- they really do think hard about the implications of their changes -- while many companies let loose a genie without thinking about the consequences. But even Google's attention to consequences tends to be limited to consequences within their own search engine economy, and not necessarily to the wider economy. More on that tomorrow.

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MikeInAZ   [03.24.07 10:21 AM]

One overlooked fact regarding mortgages is that the loose lending was not unique to subprime mortgages. The risky behavior is found in Alt-A and prime loans as well. There was and is an over reliance on FICO scores, instead of the borrowers' ability to pay or affordability (ratios are out of whack). So currently subprime is getting all the negative exposure, but within the coming months, you'll see other grades of loans having trouble as well. As the recklessness was systematic.

The previous dotcom bubble had an over reliance on eyeballs and traffic, instead of profitability and sustainability.

Mnkytalk   [03.24.07 10:29 AM]

You're right Tim. I think almost everything evolves through the time and corrects itself over time. I work for one of the largest financial corporations and I can hint you for sure that the game plan is changing very rapidly as we talk!

There are many other things involved in SubPrime lending but the foremost - need drives everything. When people are ready to risk by taking a high interest loan..they are in theory creating a pocket for profit - and thats what lead to NINJA..they've created a niche, and secondly - don't take me wrong companies made billions on interest. So, the plan paid of well for companies. This phenomena increased the interest rates but there is no rise in income, and bad economy lead to foreclosures.

But I guess it's time to realize now! what goes around comes around. Good to see a different kind of post on Radar..keep up the good work!

Aaron   [03.24.07 10:39 AM]

In terms of AU its not the technology that was a problem. It was the business rules behind them. Same will be true for web 2.0

pwb   [03.24.07 11:37 AM]

That's weird. My understanding is that mortgage securitization dhas had the opposite influence: that is, lenders will only offer product that they can securitize which is a very narrow list.

Paul Knag   [03.24.07 11:55 AM]

It is always a wise exercise to observe the excesses and failings of others and try to find the lesson in it for oneself.

If the NINJA loan is to symbolizes the hubris of the mortgage/mbs/subprime debacle, recent S-1 filings of several web 2.0 companies in the red could foreshadow the hamartia to come that you allude to.

Tim O'Reilly   [03.24.07 12:33 PM]

Wow, Paul -- hamartia -- what a great word. I haven't heard that since my classics days at Harvard when I saw it as άμαρτία. I don't think I've ever heard anyone use it in an English sentence outside of a classics discussion. It's a great word, and most apt. (For those of you without the classics background, see )

Jim S   [03.24.07 02:00 PM]

The one thing that seems to be left out of all of the public discussions of subprime lending is the insane debt burden and interest rate risk that individual consumers are willing to take on. They are not hapless victims, they are sentient but not always responsible beings making decisions without apparant thought to the realities of their financial situations or the risk that they are accepting.

There are clear issues in the lending system with the separation of incentives and downstream risk that you point out. But at the end of the day if a consumer accepts a loan that requires 40+% of their pre-tax income to service and has a high liklihood of higher payments in the future from interest rate increases, don't they own the responsibility for their actions?

My brother is in real estate and for years we've just shaken our heads at the willingness of everyday Americans to be house poor and debt burdened (conversations that usually occur after he has attended a particulalry ridiculous closing).

Tim O'Reilly   [03.24.07 03:59 PM]

Jim, I can't disagree. But at the same time, recognizing human frailty, a person of sound moral sense does not appeal to that frailty, knowingly creating harm to another for his or her own profit.

We have way too much of that in our culture, and it's not OK to pretend that there isn't a moral dimension to the ways people make a buck on the backs of their fellow human beings.

Jim S   [03.25.07 08:10 AM]

Tim, I agree with you and I was in no way trying to lessen the moral responsibility of those who would intentionally profit off others in this way.

It's just that I think the discussion of pushing subpar loans (morally reprehensible) and the taking on more debt than is prudent (personally irresponsible) are obviously related but also in some ways orthogonal. The person who accepts the risky loan and then goes on to lose their house has been used, but not without their own collusion and choice; however, it is usually discussed as though they had no personal responsibility in the outcome.

Anyway, I agreed with your fundemental thesis that the separation of incentives and risk is fundamental to this problem. When the neighborhood bank issued and held the loan, the incentives and resulting risk tolerance were much different and everything from personal debt load to home pricing was constrained.

However, what a bank is willing to loan should never be the only factor to consider in figuring out how much debt one is willing to accept. Surprisingly though, it too often is the only factor at play.

Marianne   [07.11.07 08:26 PM]

I believe that subprime lending is a lot like Jessica Rabbit...not bad, just drawn that way. There are companies, like Ocean Capital in Rhode Island, that make financing available for sole proprietor businesses that would not be able to secure financing in the traditional marketplace. We've all got to start somewhere and oftentimes a stated income loan is the only means to start one's business.

Ntsike   [10.21.07 01:31 PM]

There was a lot of loose money in investor’s wallets as we moved into the 21st century and investors are always looking for rates of return that exceeds current market rates. These investors invest in loan pools as historically they tend to be safe investments, and all of the professional real estate guru's were predicting continually increasing appreciation in real estate prices. On the other hand you have Congress had changed the deductibility of interest charges, except mortgage interest. This was a keg of dynamite with Americans trying to live the American DREAM by using their home’s equity as a credit card.

Lee W   [11.10.07 01:32 PM]

Finding the root of the problem is like peeling an onion.

From my personal experience 60% of the blame for the blowup belongs in several main camps.

The big 10 banks / investors, wall street, and the mortgage insurance companies.

If that select group did the due diligence that was in place, but ignored, a major amount of the pain could have been avoided. At the peak of the mortgage boom quality control - due diligence was thrown out the window.

Verification of income, credit, employment and home value took a back set to increased loan production and record profits. Instead of increasing their staff for these functions they all just ignored this key step in the process.

A FICO score is is a number that represents the borrowers historic ability to pay. It is not a guarantee that the home value is correct or that the borrowers can afford the payments.

Sub prime has been around in it's pre-crash form for almost 20 years. If the problem was really that a sub prime loan was a "bad thing" the market place would not have supported that type of lending for almost 2 decades.

Sub prime lenders did not make up the rules. The big banks and wall street did.

A sub prime lender only offered what the big boys told them they were willing to buy.

Another 20% goes to outright fraud - committed by every group. Brokers, appraisers, closing attorneys, bank reps, and borrowers.

It did not take long for dishonest people to take action when they discovered that the barn door was left open. That's exactly what happened when QC was ignored and considered an unnecessary expense.

I think the final 20% can be give to the borrowers who made bad decisions.

So now the industry is left with only a few sub prime lenders standing (owned by wall street or the big 10) - the big 10 for fannie, freddie, and FHA lending and politicians jockeying for position for the slaughter of what is left.

The person who suffers the most is the borrower.

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